Katrina's Liability Implications

October 3, 2005

(Edited transcript from audio recordings)

9:15 a.m.	Registration
9:30	Panelists:	Joanne Doroshow, Americans for Insurance Reform
		Martin F. Grace, Georgia State University Robert W. Klein, Georgia State University
		Adam Scales, Washington and Lee University
	Moderator:	Ted Frank, AEI
11:30	Adjournment

Proceedings:
TED FRANK: Good morning. Welcome to our panel on Katrina’s liability implications. My name is Ted Frank. I'm a Resident Fellow at the American Enterprise Institute and Director of the AEI Liability Project.
 
Hurricane Katrina was a catastrophe unprecedented on American soil. We know about the tragic loss of life, the destruction of cities along much of the Gulf Coast, including my home town of New Orleans, the questions of disaster response, the hundreds of billions of dollars of government money that will be spent on aid and reconstruction.
 
But in the aftermath, there is also the issue of how the liability system deals with catastrophes of this nature. One of the trends of the liability system today is the idea that no loss should remain uncompensated so long as there's a deep pocket tangentially related that can cover the loss. And we're starting to see lawsuits, from small ones alleging price gouging over real estate transactions in Baton Rouge, to larger class actions against oil companies seeking to hold them responsible for the storm surge in Louisiana.
 
This panel will focus on one class of these lawsuits, the lawsuits that the Mississippi Attorney General has actually filed and plaintiffs' attorneys have threatened to file over the flood exclusions in homeowners’ insurance policies.
 
Reformers have long suggested that the tort system should more closely resemble that of contracts, but what we're seeing today is with these lawsuits is the arrow in the opposite direction, seeking to move the law of torts into the law of contracts.
 
We have an excellent panel here that will address some of these issues. We have the economists on the left, and the lawyers on the right, but you shouldn't draw any conclusions from that.  I'll introduce each panelist in turn. They'll speak for about 15 minutes. We'll have some inter-panel discussion and then we'll turn it over to audience Q&A.
 
Our first speaker, Robert Klein, is the Director of the Center for Risk Management and Insurance Research at Georgia State University in Atlanta, and a Senior Fellow with the Wharton Financial Institution Center. He is an expert on the economics of insurance markets and public policy and regulatory issues in insurance. He has testified frequently at legislative and regulatory hearings on significant issues affecting insurance consumers and the industry. Prior to joining Georgia State University in 1996, Mr. Klein was the Director of Research and Chief Economist for the National Association of Insurance Commissioners. He currently serves on the editorial boards for the Journal of Insurance Regulation and Risk Management and Insurance Review.
 
Mr. Klein?
 
ROBERT KLEIN: Thanks. My job here as the non-lawyer, just an economist, is to try to set some context for the other speakers in terms of what I see as some of the stakes that are motivating the lawsuit in Mississippi and other lawsuits that are occurring or will occur. I view this as a high stakes game with many players, many dimensions; and it's going to have many stages. And this particular lawsuit is one particular and important component of that game.
 
The stakes are high. Conservative estimates of the total amount of property losses, residential and commercial, are around this time $170 billion. And one estimate places about $100 billion of that as being uninsured. So that in itself is a lot of money to play, and it doesn't include probably a lot of other losses that people suffered from this event, either insured or not insured.
 
So there's a game being played to try to recover these losses from whatever source possible, including insurance companies who did not believe that they had contracted to pay those claims. This is game that's going to play out over many months and years. It does have very significant implications for the Gulf Region, taxpayers, and the insurance industry.
 
And what I'm going to try to do is talk a little bit about what's at stake here, and some of the factors associated with flood insurance and homeowners insurance that are relevant to this case.
 
In terms of insured losses, estimates by modeling firms at the high end place about $60 billion in private insured losses.
 
That would be both commercial and residential. And early estimates of the portion paid by the Federal Flood Insurance program, which is the primary flood insurer for residences and small businesses, is about $10 billion.
 
Then we have uninsured losses. And these estimates are probably the fuzziest at this time because at best you can make some modeling estimates using aerial imagery. And the question how much is that from wind damage caused by Katrina and how much is that caused by flood damage from Katrina, which are two very good questions.
 
And then we come to this issue of federal assistance. Some people have said that it might ultimately amount to $200 billion. To date, about $70 billion has been appropriated, and obviously there's more to come. It's just a question of how much.
 
In terms of estimate of flood losses, this is a question that's particular relevant to obviously this lawsuit and other lawsuits that might be filed.
 
There's a modeling firm called AIR Worldwide, which just put out an estimate on Thursday, which estimated total flood losses from Katrina at about $44 billion.
 
And, as you can see from this chart, a significant amount of those were New Orleans. Another portion was from the Louisiana storm surge loss.
 
And then another portion, about $4.4 billion, from the Mississippi storm surge loss.
 
Now, again, a certain portion of these are going to be insured. We know at least approximately maybe $10 billion from the Federal Flood Insurance Program. How much from private insurance is going to depend upon how many probably commercial properties had purchased private flood insurance. But I think it's fair to say that a significant amount of these flood losses were probably not insured. And any guess I would try to make would be very speculative, but in the speculative range something between $10 billion and $30 billion is probably not out of the question. And it could end up more.
 
More hard data will become available over time, and then as that data becomes available, we'll have a better idea of this, and particularly as lawsuits proceed.
 
In this next slide, what I want to just show you is that the percentage of homes that are estimated to have flood insurance along the Gulf Coast varies significantly. But you can see that there are some areas, with fairly low percentages as best can be estimated. If you look at the three Mississippi counties that were directly along the coast that were most affected by Katrina, you see that a relatively small portion of homes carried flood insurance.
 
Now, we'd expect those numbers to be a little higher closer to the ocean, but again we don't know exactly what those numbers are and it's reasonable to assume that there's still a large portion that did not have flood insurance.
 
If we look at Louisiana, we see a pattern that varies. Some areas the penetration of flood insurance seems to be at least above 50 percent; in other areas, quite low.
 
So again, that suggests that there are going to be a significant amount of uninsured flood losses, and that's why there is obviously some motivation among different state officials including the Mississippi Attorney General in terms of trying to recover those losses from other sources.
 That raises a question: what about flood insurance? Why don't more people buy it?
 
Well, actually, Federal Flood Insurance is relatively inexpensive, and it's relatively easy to buy. In many communities that have essentially qualified for the Flood Insurance Program, there are probably about at least 20,000 that have done so, and from what I've seen, I think most of the areas in which Katrina caused damage, all those communities qualified for the program.
 
However, purchase of flood insurance is only compelled by lenders in what are considered to be high hazard areas, and those are areas that are considered to be 100-year flood plain zones. It's probably fair to say that obviously a lot of flooding did occur in those high hazard areas, but some flooding also occurred in areas that were outside the high hazard areas. So people in those areas were not compelled by lenders to carry flood insurance, although they could have voluntarily chosen to purchase it.
 
The enforcement of the lender requirement was also somewhat lax before 1994. And so anyone that had a mortgage pre-dating 1994 might have been less likely to have bought flood insurance because their lender required them to do so.
 
So we then come back to the question well, why don't more people voluntarily choose to buy flood insurance? That's a very interesting question—I guess you'd call it the $30 billion question. And there's several answers to that. Studies that have been done in the past, for example, in the floods of 1993 in the Midwest got a lot of attention and some efforts to try to get more people to buy flood insurance and those efforts did have some success. But obviously, they've fallen far short and there are going to be more questions, and this is something that people are going to be investigating. We're going to be investigating at Georgia State, and maybe there will be some opportunity to talk about that in the question and answer.
 
Another point that I wanted to make in sort of setting up this discussion is that there might be some people harboring a misperception I guess that the insurance industry in the area of homeowners insurance is flooded with cash just sitting there waiting to cover not only claims that they contracted to pay, but even losses that they didn't contract to pay.
 
And the point I'm trying to make here is what I'm showing in this chart are something called an operating ratio for homeowners insurance. And basically, an operating ratio is taking the premiums that insurers collect as a denominator and then in the numerator you've got the losses they pay, the expenses to write the business, and then we subtract the investment income from the numerator that they earn when they hold those premiums to pay claims.
 
So basically, if they have operating ratio above 100, they're losing money, and if they have an operating ratio below 100, they're making money on that particular line of insurance.
 
And you can see, from this chart, that in many years, they've been losing money on homeowner's insurance. And you see a particular couple years: 1992, which was Hurricane Andrew, and 2005, which is a projected figure by the Insurance Information Institute that's about comparable, at about 150, they're going to lose a lot. This is for the wind damage claims from Hurricane Katrina, and other claims that they have contracted to pay. So it doesn't add in the additional liability that might be created should the Mississippi Attorney General's lawsuit prevail or other attempts to get them to pay uninsured losses that would certainly add to that burden. And, as you can see from this chart, there not a lot of extra money there that's been set aside to pay those kind of losses.
 
In terms of objectives and strategies of the what I consider to be the important players here, I wanted to make a couple points. One is that insurance companies really, at least in my view, do seek to pay legitimate claims. I mean that's what they're in business to do. And if they don't do that, then there's not a reason for their existence. Certainly, there can be disputes about, you know, how much a claim should be, but they're really in business to pay legitimate claims, not avoid it.
 
They also have an interest in preserving their reputation, because if they get a reputation for not paying claims, they're not going to sell insurance, so that's a concern to them.
 
They also have to be prudent financial managers, and that means pay obligations that they're contractually obligated to pay, but just to hand out money or write blank checks would be very imprudent management of their companies and would be harmful to their policyholders and stockholders.
 
Insurance regulators’ job is to enforce laws and regulations and they have I would say at least a certain amount of respect for the insurance contracts that are written and they approve, and so they recognize the problems that can be created if those contracts are undermined.
 
At the same time, they're going to be inclined to try to voluntarily encourage insurers to be--how shall I say it--relatively generous in paying claims when there might be some ambiguity about whether a loss or a certain amount of damage was caused by wind versus water.
 
But I think that's as far as they really want to go, because to try to compel insurers to pay what are clearly flood clause losses would create huge problems for the market, and the regulators are particularly concerned about maintaining viable insurance markets going forward, because they have a responsibility not only to people who suffered losses from Hurricane Katrina, but to all of the people in their jurisdiction that have insurance and still need insurance for the next disaster or the next kinds of claims that will follow.
 
Quickly, the federal government, as we know, is involved in a certain amount of damage control. They want to retain political support, so it's not surprising to see a lot of assistance coming from the federal government and more assistance will be asked for. Of course, there's a debate about that because, again, it's a balancing of interests among different people.
 
Finally, we have other state officials, and in this group, I am excepting for the moment the Mississippi Attorney General and focusing on legislators and governors. Obviously, they want to recover losses as quickly and as much as possible from legitimate sources so they all want to see the insurance industry pay what they owe. But they know that there's a lot that's uninsured. And for those types of losses, these officials will seek to obtain assistance, primarily from the federal government and other outside sources. They also want to maintain political support, and they have to balance the interests of people who were directly affected by the flood with those of other people in their jurisdictions who count on the insurance industry and in viable insurance markets.
 
So in terms of concluding observations, I'll just say that, in my view, trying to force insurers to pay for uninsured losses will do great harm to the public interest. I think that individuals, firms, and governments much deal with the consequences of their choices, whether those consequences are good or bad in their choices. Had they to do them over again, they would choose differently.
 
I think helping those who need help is and will be a matter of public policy. There are people who have suffered significant losses that are not insured, who have limited means, then that's something that the government and the federal government specifically can take up as a matter of public policy.
 
And finally, there are many issues and problems in managing risk and cost of disasters that need to be addressed. This lawsuit is one, and the liability question is one significant part of that.  There are many other issues and problems. And we intend to continue to research these and look at these, and I hope that all of you do the same.
 
And with that, that concludes my comments and I’m ready to pass it back to the next speakers.
 
MR. FRANK: Bob, there's a proposal sitting out there in Congress to let people retroactively purchase flood insurance. If they had purchased 10 years of flood insurance retroactively then the government will cover them.
 
Do you have any comments on that?
 
MR. KLEIN: Well, there’s kind of a technical economist term to describe a proposal like that. We would call it goofy.
 [Laughter.]
 
Kind of a goofy idea. I can understand some of the motivation behind it, but it totally destroys the insurance principle.
 
So basically, if you want to help out people who really need help, give them a loan, give them a grant, call it whatever you will, but don't make flood insurance retroactive because it greatly undermines any incentive for people to purchase flood insurance in the first place. So I don't think it's a very good idea.
 
MR. FRANK: Thank you. When I'm putting together panels, I like to say that I like to schedule Notre Dame, in other words, I want to have people up on the panel who can challenge our assumptions and put our ideas to the test. And our next speaker is well qualified to do that.
 
Joanne Doroshow is President and Executive Director of the Center for Justice and Democracy, and also Co-Founder of Americans for Insurance Reform, a coalition of a hundred consumer groups from around the country working to strengthen oversight of insurance industry practices. She is an attorney, who has worked on civil justice issues since 1986, when she first directed a project for Ralph Nader on liability and the insurance industry. The Stern Family Fund named her as the Public Interest Pioneer for 1999. I don't know what's happened in the six years since, but she is a nationally recognized civil justice expert and a frequent guest on TV and radio, and has testified before Congress and numerous state legislatures around the country.
 
Joanne Doroshow.
 
JOANNE DOROSHOW: Thank you. Well, in those years, we've been able to form an organization called the Center for Justice and Democracy, and we're growing and hope to continue out there for years to come.
 
One of our projects, as you just mentioned is Americans for Insurance Reform, which is a coalition of about a hundred groups around the country. Normally, AIR, as I'll call it, works on issues related to the liability and insurance crisis that periodically happens in this country, which drives efforts to restrict or weaken the civil justice system, which we strongly oppose.
 
But when Katrina happened, we decided to attempt to do what we could as a public interest coalition to help the victims down there in some small way. So we created a hotline for those with complaints and difficulties dealing with their insurance companies during this period of time. And anybody listening, watching, certainly if they do have a problem, and they are a victim of Katrina or Rita to please give us a call and let us know. We are trying to monitor these complaints as best we can and refer people on to other agencies, other phone numbers even, to the extent we can.
 
It's still very early, of course, in the claims process for people, but just to give you a little bit of an overview of the kinds of problems that we're seeing so far: there are really massive problems due to delays and failures of companies to send adjusters to these areas. Now, not every company is having as bad a problem as some others, but in many situations these are really life or death crises for people who already have been through a horrible experience and now they're being sent into financial ruin, and perhaps even worse because they cannot get responses from their insurance companies.
 
This is really critical in terms of the living expenses that people are entitled to under their homeowners policies. Many are being told that adjusters won't go down to the area or they won't be able to get their living expenses until the adjuster gets to see the property. Some of these properties are under water or they can't even get into these areas.
 
We have disabled veterans calling us. We have elderly people who have nothing but the clothes on their back. It's a terrible, terrible situation for many people. Also, companies are not recommending contractors so that people can remediate the damage to their home.
 
This was particularly a problem in New Orleans in areas that were not flooded, but were heavily damaged due to wind and then Rita came in, and during that period of time between the two, people were trying to repair their homes and get adjusters in there. They couldn't, and so Rita then did even worse damage than was necessary.
 
Another very big problem is that people were not sold flood insurance because they were misled. First of all, particularly people in Mississippi were sold policies with hurricane endorsements or hurricane deductibles. People thought they were getting coverage for whatever might happen in the hurricane. We heard from, for example, one woman who a year ago happened to just call her insurance agent just to make sure that she was covered by any kind of flooding that might happen during the hurricane, and the agent said no, you're not. And he had never even explained that to her; that there are these exclusions in these policies. It's an extremely confusing contract that people are handed, and so this is going to be I am sure the basis for much litigation because, as I'm sure we'll get into in this discussion, any kind of ambiguity like that has to be resolved on the side of the policyholder.
 
But meanwhile, these people have to fight. And we're even finding situations where people have experienced no flood damage whatsoever, for example, a home that was on stilts near the Gulf in Mississippi. The home was completely destroyed. There was no water. There was no flood damage. Their carrier is telling them that this is all flood-related and they're not going to pay.
 So we get into this issue of wind versus flood. And, you know, the bigger issue of whether or not any of these claims are going to get paid or whether these people are going to have to fight in court. These homeowners' policies cover wind, storm. They cover wind damage and rain, and the issue is if there was any flooding at all, does that suddenly relieve them of the responsibility to pay anything under these policies?
 
And then you've got situations where people don't have flood insurance, or when they have both, how that allocation is going to be made between what was wind damage and what was flood.
 
Now, if you listen to the insurance industry statements right at the time Katrina was happening, you would get the impression that they intended to pay none of this. It's bad enough that they did little to inform people ahead of time that these policies did not cover flood. But their first thought after Katrina happened was to disseminate this message that they were not going to be responsible for anything dealing with flooding.
 
The Property Casualty Insurance Association of America on August 31st put out a statement right away: if those levees break, we're not paying. And every day the same kind of message is coming out of this industry declaring most of the damage flood-related and this was obviously wrong on both the law and the facts.
 
Factually, much of this damage was wind-related. It's obvious that many homes are destroyed by wind before maybe they were flooded or their homes are weakened as a result of the wind. Or in areas where there was no flooding, there was severe wind damage and homes were destroyed. There are people telling us on the hotline that there are certain companies that have just declared certain areas all flood damage, just because an evacuation was ordered due to flooding, even though the homes are not damaged by flooding.
 
So factually, there's a tremendous amount of controversy here, and a lot of this damage was obviously due to wind. And then when you go into the legal landscape, which I won't go into too much detail, because I think Professor Scales will probably address that a little bit better than I could, we have very well settled law in Mississippi after Hurricane Camille happened, Supreme Court cases which on these very same kind of fact patterns, where there was wind and flood damage and the insurance could not dodge these claims. They had to pay. These are very fact-driven scenarios that juries have to decide.
     
That's why attorneys are really going to be critical in these situations. They're going to have to take these cases to court, where the insurers are refusing to pay. There is good law also in Louisiana, concurrent causes kind of law that would help those cases as well. And then you've got the legal issues of ambiguity and misleading sales tactics, which are also very significant here. Very ambiguous policies, particularly in Mississippi, where you had hurricane endorsements being sold, and people did not understand that there was a flood exclusion, and in many cases that we're hearing from the hotline, people were told they didn't need flood insurance. Don't worry about it. Maybe these were sort of sales tactics by some of the agents who may have been competitive with others and dissuaded people from buying flood insurance. But we're hearing this from people. There may have been very seriously misleading sales tactics going on and I certainly hope some of these lawsuits get into this. I know that the Mississippi cases promised to do that.
 
But, you know, the industry was aware of this legal landscape when they wrote these policies. So it's really morally reprehensible for them to have been immediately coming out saying they were not going to cover this damage; that they're not going to pay their claims. And now they're even threatening to pull out of states if they're forced to pay.
 
And the other really reprehensible thing that we saw was right after Katrina happened, there was a conference among insurance executives where already they were talking about the market opportunities that they were going to be taking advantage of as a result of this hurricane. This is when people were still being pulled out of these homes.
 
So if they're concerned about their reputation, well, they ought to be concerned because so far how they've been acting has been really horrible in terms of how the public has been seeing their response here.
 
Now, you know, we can accept the fact that this is a serious loss for the industry. This is the worst year maybe for catastrophes ever. But this industry made $38 billion last year in 2004. They've made unprecedented gains, and in 2005 those gains continued. So even at the high end of loss of $60 billion, with, you know, up to maybe half of that flood, covered by the taxpayer, as Bob Hunter who we work with quite closely, who was the Federal Insurance Administrator under Carter and Ford, former Texas Insurance Commissioner, recently wrote in a letter to the editor saying that part of that $30 billion is going to get written off in federal taxes. So you've got a loss of capital of maybe $20 billion for this industry, and you look at their profits just for the first half of this year, and it's about what that was. So there's no reason for them to be screaming like this.
 
Now, there are ways to handle these problems. And the Consumer Federation of America and Consumer's Union have written a letter to all three insurance commissioners, in Alabama, Louisiana, and Mississippi, laying out what they would recommend.
 
First of all, there needs to be an immediate moratorium on cancellations and non-renewals. Now, I understand Louisiana has already instituted an emergency rule on this. After Andrew, Allstate announced they were going to cancel 300,000 policies, and just was going to leave people without any recourse.
 
So what the commissioner there did is that they ordered a moratorium on cancellations and non-renewals. This has to happen here. The state has to step in, and they have to give time to develop a plan that if companies are going to pull out, what people are going to be able to do. And what they probably ought to do also is institute a rule that they can't cherry-pick. If you're going to pull out on homeowners’ policies of a state, then you can't sell auto. You can't sell health. You can't sell life. You can't sell other things as well.
 
There needs to be a freeze on rates right away. The insurance companies don't get to raise rates off of Katrina. These rates were already accounted for in the market by models that were instituted after Hurricane Andrew, which were meant to stabilize rates so that there were not these huge ups and downs after hurricanes. And these models predict hurricanes way into the future, sometimes 10,000 years into the future, including category five hurricanes smashing into Miami. So the kind of loss that has happened on the Gulf Coast should not be a surprise to anybody. The losses were already accounted for, and homeowners have already paid for this, so they should not be hit with rate hikes.
 
There need to be many more resources devoted to claims handling, as was done in Florida. The state needs to have oversight over this, and there needs to be some federal oversight over these allocations of wind versus flood. There's a conflict of interest obviously for insurers to want to declare more area flood damage because then the taxpayer picks up the tab, not the homeowner policy carrier.
 
So in conclusion, I want to say that these companies and their agents went to these areas. They aggressively wrote policies to get market share. And they can't now scream they don't want to pay these claims. They knew where they were writing these policies. They knew there were going to be hurricanes. They have to be responsible for this.
 
We're concerned that when the media turns away from this area, and the cameras go off, about what's really going to happen to these policy holders. But we'll do our best to keep monitoring that situation. Thanks.
 
MR. FRANK: Joanne, what I didn't hear there was any discussion of Mississippi Attorney General Jim Hood's lawsuits, seeking to have declared every single flood exclusion unconscionable. Do you have any comments on that?
 
MS. DOROSHOW: Well, from a legal standpoint,--perhaps Professor Scales would be better at analyzing that--I think that it's going to be a difficult argument for him to make. I think misleading sales tactics, consumer fraud, ambiguity are probably stronger elements of that suit. So I'm not sure that he'll succeed on the unconscionability aspect, but it was a great thing for policyholders to see him stepping in there and doing something to help them, because right now they are in a terrible situation, and very scared. And at least they see somebody from the state fighting for them. I don’t know whether the unconscionability part of that is going to succeed, but I think other parts of his suit will.
 
MR. FRANK: Thank you. We'll now move on to Professor Adam Scales, who's at Washington and Lee University School of Law in Lexington, Virginia, and currently a visiting professor at the University of Connecticut.
 
His work on torts and insurance law has been published in the Iowa Law Review and most recently in the Wisconsin Law Review. He is chair of the Association of American Law School Section on Insurance Law and before joining the faculty of Washington and Lee in 1997, Professor Scales spent two years as an associate at the Minneapolis law firm of Faegre & Benson, and then served as law clerk to Judges Michael Davis, David Doty and Robert Renner, all in the District of Minnesota. Professor Scales.
 
ADAM SCALES: Thank you. We should have changed the order of seating because I find myself in between two somewhat apocalyptic versions of what's happening.
 
There are three things I'd like to discuss. One is the background and texture of the judicial regulation of insurance contracts, then some close attention to the Mississippi lawsuit, and then some thoughts about the interaction between the private insurance market and the Federal Flood program.
 
So the first thing to keep in mind is that insurance law over the past 40 years, but even before that, actually has come to have a lot more in common with the law of products liability than the law of contracts. And the reason is that for hundreds of years, relationships between people were regulated primarily through contract and transactions were relatively simple. People understood what they were buying. But in the products context, as things became much more interesting, as we moved from wagons to cars to things that are mass marketed, it was more difficult for the average consumer to truly appreciate exactly what he was getting for his money.
 
And product liability law responded by reducing the emphasis on contractual notions of liability and, as Ted alluded to a few moments ago, emphasizing the tort dimension of product liability. The exact same dynamic has taken place for essentially the same reasons in insurance law. Insurance contracts are remarkably complicated instruments, at least with regard to the transactions ordinary people engage in. They don't understand what's in their insurance contracts. They have not read them. They would not understand them. I could sit with any average policyholder and spend an hour explaining various fascinating provisions in the insurance contract, and within a few hours that education would probably have been lost.
 They have to be complicated because we ask them to do quite a bit. But at the end of the day, it is not the same as walking into a grocery store and buying a gallon of milk. It's very difficult for people to know what's in them.
 
So as the contract notion has receded, and the torts notion has become ascendant, courts have put themselves in the position of making what we hope are educated guesses about what reasonable consumers of insurance would demand if only they had the opportunity to spend some quality time with me and our other panelists, of course.
 
And the risk of this, of course, is that we undermine the certainty that is hoped to be found in written instruments. And courts sometimes guess incorrectly about what consumers would prefer, and these are huge risks for the judicial regulation of contract.
 
What we've seen is a cycle of drafting and redrafting of insurance contracts that really is nothing new. This has been ongoing for a couple of hundred years. It began to accelerate in the modern era, about 150 years ago. And the dynamic is this: An insurer proposes a bit of language (and until relatively recently this language didn't need to be approved by a regulator), the policy is sold, and a dispute arises and the claimant says, “Well, I didn't know. This wasn't in the policy. If I had known, I wouldn't have bought it, or it's unfair or it's ambiguous.”
 
And courts, depending on the consumerist ethos they happen to bring to chambers that day, may reject the contract as interpreted by the insurance company, and say well, this was a little bit ambiguous and so this plaintiff is going to win.
 
Now, what typically happens then is that the insurer redrafts the contract with a copy of the adverse opinion close at hand, and says, well, the Court said we didn't put this in bold type. We'll put this in bold type. We didn't make very clear that we wouldn't cover losses--no way, no how--related to flood. So we'll put that in there now.
 
And this is exactly what happened in the aftermath of a number of interesting losses in the 1980s and '90s when insurers inserted language in their contracts that is described as anti-concurrent causation language. And this language is designed, if read literally, to exclude losses that have any connection whatsoever to flooding.
 
Now, the problem with this is, once again, the expectations of the policyholder. If you were to read your standard homeowner's insurance contract--and that's a fascinating exercise. I commend it to all of you--you will see that if flood had anything to do with a loss, that you appeared not to be covered. This, of course, is a nonsensical position on its face. We have seen and can readily imagine many cases where flooding weakens a structure, which is subsequently destroyed by wind, perhaps vice versa. Sometimes they may act at the same time, and we have a great deal of difficulty reconstructing the events later.
 
That's the literalist position is implausible is actually demonstrated by what insurance companies tend to do, which is not to say there's no coverage, but to say well, there's only coverage for that portion that we can segregate out and assign to wind losses.
 
And that's because the cycle of drafting and redrafting that's pushed insurers to what is essentially an absurd bit of language on the issue of causation.
 
Now, this does not mean that insurers should have to pay for what we'll call pure flood losses, of which there are undoubtedly many in the wake of Katrina. But it does mean that there is both a factual and legal interaction here.
 
Now, let me spend a moment talking about the Mississippi lawsuit. Like all lawsuits, there are claims that are more deserving of our attention and a respectful hearing than others.
 Let me touch upon the idea of misrepresentation. Now, insurers actually have a great deal of difficulty disciplining their agents, who are, after all, in business to sell, and it's a fundamental dynamic that explains a great deal of the difficulties that insurers find themselves with in all manner of cases.
 
I have not yet seen evidence of widespread misrepresentation to people; that they were getting full coverage for anything. But I have no doubt that there was probably some occasional misrepresentation. But more likely, the story that Joanne told a moment ago was probably a very plausible one. Often times, people just aren't thinking about it. And agents may assume that because relatively few people are demanding flood insurance, there's no need to lengthen the time of this transaction by explaining that to the prospective policyholder.
 
But it's clear that people do not understand much about the interaction between the windstorm and hurricane coverages and flood coverages. The GAO acknowledged this as a possible explanation for why the participation rates in the flood insurance market is so low. I think that's only one of several explanations. But once again, people simply do not understand their contracts very well.
 
I do believe that a number of the Mississippi claims are overreaching. It would be inaccurate in my judgment to describe an effort to segregate flood losses as unconscionable. What is appropriate is an effort to cabin flood losses, to restrict them within the policy so that the insurer is not paying for things that are purely flood.
 
And if you look at the Mississippi complaint, with some care, you'll see that these ideas of reasonable expectations and the ambiguity of policy language are woven into the substance of the AG suit.
 
I believe that in cases that involve mixed causes almost all interesting events stem from a mixture of causes covered and uncovered. I believe that the case is sound at its core. And as has been pointed out, these are very fact- intensive--one might say fact-smothered--areas of dispute. And it is very difficult to resolve these at a high level of abstraction.
 
Now, let me spend a moment talking about the flood program at the federal level, not in any great detail, but just to illuminate why this is so problematic I think for property insurers. There is a hazy factual and legal border between windstorm and flood, a border that insurers have attempted generally without success to make more definite through the anti-concurrent causation language.
 
But, of course, we do have the Federal Flood Insurance Program. It's a tremendous subsidy. About 28 percent of people pay subsidized rates, and those rates themselves are 35 to 40 percent of the actuarial rate. So it' s a tremendous incentive to maintain homes in flood-prone areas.
 
Well, because private insurance companies cannot reliably police the wind-flood border, what we have is the possibility that they are, in fact, paying out for claims that they have not priced into their models.
 
Now, it's difficult to assess that, just as it's difficult to assess these different estimates about losses. Insurance companies like all actors have a variety of incentives they might bring to bear in describing their losses, and, as I've looked at the estimates from third parties, it's not clear to me that there is a restrictive and stable conception of flood loss that excludes anything that has something to do with wind. It's very difficult to take this into account, and I haven't seen studies that segregate these out very clearly. It's analogous perhaps to the different counting standards after the 2000 election. If you use a restrictive standard and you can see some light through it, well then maybe we get one result. And if we use a different standard--we let it all in--we get a higher end result.
 
And that's a very complicated task, but the flood insurance program encourages the demand for homeowners' insurance. It's not a direct subsidy to private insurers, but it makes it economically plausible for people to maintain homes in flood-prone areas, and, therefore, raises the demand for insurance.
 
Now, the very uneven participation rate complicates this thesis somewhat, and I think that is part of the problem. The other problem is that the flood insurance program, while I think almost it's mostly the write your own market. Private insurers perform the administrative tasks and sell the policies, and the government provides the cash. These are governed by different rules of law than private insurance, and I think part of the problem is that these are not quite in sync. I do not believe that flood insurance contracts really make any provision through interpretation or otherwise for wind-related events; whereas, homeowners policies, which are purporting to exclude flood necessarily comprehend some flood loss as part of their operations, even though that's not what insurers intend to do.
 
It might be better to explore how we can develop the private market for flood coverage to ensure that insurers are getting the premium for the services that they are asked to deliver.
 
A couple of quick points about some of the earlier panelists.
 
There was one comment about how we want people to think very carefully about their decisions. And we want them to live with the consequences of their decisions. And I think we can all see as a result of the billions of dollars that being cranked up in Congress that we have a very difficult time in this country making people adhere to their decisions.
 
But if you look at the market for flood insurance after 1994, while the evidence is mixed, it still appears that there is substantial non-participation even among lenders who are required to buy the flood coverage on behalf of their homebuyers who themselves don't buy it. You would think that that market for flood coverage would work really well. You have sophisticated parties and then a law that requires them. And yet, still, there appears to be substantial non-compliance.
 

Another point that was made involves the reputation of insurance companies. It's a very slow moving event. It's not much of a factor for most consumers of insurance. There are very few people who could name more than six or seven large insurance companies. People do not spend a lot of time comparing coverages, which they would not understand if they did. They shop primarily, almost exclusively, on the basis of price, which is actually one of the reasons why the law developed the way it did. I have, as an insurance professor, my students are always coming to me when they've had car accidents and their insurer is somewhat reticent. And about 90 percent of them use one very well-known, highly advertised insurance company with low, low rates.
 
So there are plenty of reasons to be skeptical of market forces here.
 
MR. FRANK: Thank you. The economics of the market for flood insurance are very interesting and hopefully Martin will deal with this. But certainly as we talk about these mixed-cause clauses, what insurers are trying to do is isolate themselves from the risk of insuring over floods. Is there anything an insurance company can do to achieve that isolation and segregate themselves from that risk, or is their only option to just refuse to insure in flood-prone areas?
 
MR. SCALES: Well, I have to say as an interpretive matter, insurers have gone as far as they can in the language of anti-concurrent causation clauses. Certainly, reading those clauses there is not what I'll call literal ambiguity. The problem that it bumps up against is the consumer protection that courts have built into the interpretation. And there's a doctrine that has been observed to be operative for decades that permits courts to override the express language of insurance contracts where that contract departs from the reasonable expectations of the policyholder. This can be misused. We might have different standards about when that misuse is occurring, but in the context of these mixed coverage cases, I think it’s an appropriate use.
 
MR. FRANK: Is there ever a time where the reasonable expectations of the policyholders should differ from the contractual language in the insurance contract?
 
MR. SCALES: Yes. Suppose we were talking about a product you were buying, a car that had certain dimensions with respect to safety features. You probably bring a set of expectations to how well a car should perform that may or may not be within the design specifications of the manufacturer.
 
But the manufacturer actually has a pretty good idea about what your expectations are. They are in the business to market products. It is very attractive to move towards a world where we could rely more explicitly on contract. I certainly think that there are many sets of consumers who do not want the judicial protection that is essentially forced upon them through non-literalist interpretations. But for the typical consumer, I think most of the time he has an expectation that the courts can fairly well intuit.
 
MR. FRANK: Thank you.
 
MR. FRANK: Batting clean-up for us today is Martin Grace, the Associate Director and Research Associate of the Center for Risk Management and Insurance Research at Georgia State University in Atlanta, where in 2002 he was named the James S. Kemper Professor of Risk Management. Professor Grace's research concerning the economics and public policy aspects of insurance regulation and taxation has been published in various economics and insurance journals. In particular, he has undertaken various studies of the efficiency of insurance firms, insurance taxation, optimal regulation of insurance in a federal system and solvency regulation. Professor Grace is a former president of the Risk Theory Society, and he is a current associate editor of the Journal of Risk and Insurance.
 Martin.
 
MARTIN GRACE: Thank you, Ted. Thank you very much for inviting me to come today. And I feel like I have a lot of stuff already on the table so I can actually go through my presentation quickly in some spots because Adam did a great job of pointing out some of the things I was going to point out.
 
So I thought I'd start off with just talking about the flood exclusion that we've heard so much about. And another policy term that has been received a lot of attention in Florida that has expanded liability for insurers, and it turns out that both Mississippi and Louisiana potentially have a very similar provision in their law. So we'll talk about the valued policy provision.
 
And I also want to talk a little bit about how contract differs from tort and why we have the two different systems. Because, as Professor Scales pointed out, we're seeing a tortification of contract law. And I wonder, do we have to go that far? I think because we can write contracts, that's what we should be looking at.
 
I'll briefly talk about the Mississippi attorney general's case. I'll talk about Mr. Scruggs’ likely suit. I have to just guess about what that's going to look like. I thought by the time I'd be here today, there would be some more about it, but I don't have any details.
 
And then I'll talk about the likely outcome of the case. Suppose Mr. Hood actually wins. And I'm not going to talk about the worst-case scenario. I want to try and give you a moderate-case scenario about what's going to happen because you've all heard about the worst-case scenario. So I'm going to talk about my reasonable expectations of the future if the case wins.
 
This is the flood exclusion part of a typical homeowners contract. Now as Adam has pointed out, it is somewhat--did you say put you to sleep? Did you say that? No.
 [Laughter.]
 
MR. SCALES: Insurance language never puts me to sleep.
 [Laughter.]
 
MR. GRACE: It keeps him excited.
 
But essentially, if we look through there and get through the decades of legal drafting it took to get to this point, we have the water damage exclusion, which basically says floods, surface water, waves, tidal water, overflow of a body of water or spray from any of these, all weather driven by wind or not.
 
This seems to cover just about everything, okay. And I don't actually want to talk about those cases that are clearly wind damage or clearly flood damage or that are fraudulently brought. I just want to talk about the simple cases, realizing that there are many complicated cases out there. And so there are legitimate disputes about what's happening.
 
A second policy provision, which is not in a policy per se, but it is part of state law, is called the valued policy provision. This is actually a good idea, and it enforces kind of a reasonable expectation of relationship between the insurer and the homeowner.
 
But take the example of a home that burns down. Say it's a $100,000 house. The policy, would say, if your house burns down or is condemned because of the fire, we will give you a $100,000. This prevents the insurer from coming back and saying, you know, you actually live in a neighborhood that's declined since this policy was written. And we're only going to give you $80,000. Well, the valued policy provision says, you have to give the stated limits because it enforces sort of the insurer to look more carefully at the underwriting and the pricing of the policy to be in line with the value of the house. So this has a long history, and it's a pretty good idea. And it stops a lot of ex post negotiation that might go on.
 
Now insurers believe this value policy provision to essentially mean that they're responsible for things that they cover. So if you cover fire and the house burns down, then they have to pay $100,000 of the policy for the house. If it gets struck by a nuclear weapon, and there's a nuclear war exclusion, then they shouldn't have to pay for that because it's excluded.
 
The same thing is true with water. Now in Florida there was a case that was decided just over a year ago that essentially said that there was some combination of wind and flood damage and that is undisputed. And the individual homeowner actually had flood insurance. The problem is the flood was deemed to be the cause that destroyed the house. It is an excluded part of the insurance contract, that the private homeowner's insurer didn't want to pay it. And this went to the district court of appeal in Florida where the district court of appeal said that it doesn't matter that the event was excluded. The house was destroyed, so the homeowner's insurance had to pay even for the excluded event.
 
So this is a case that generated a lot of controversy, and it caused the Florida legislature this spring to actually legislatively reverse the case. However, it's out there, and it could have some contagion effect and other litigation that might occur in Mississippi or Louisiana or any state that happens to have a hurricane in the future.
 
So I just wanted to briefly talk about this contract versus tort just so we would have an idea about from a law and economics theoretical point of view, what we're talking about.
 Contracts are generally set up prior to an event between people who have some kind of relationship or desire to have some relationship. So they can explain or they can enter into an agreement that sets out some reasonable expectations.
 
Torts are different. Tort is a change of liability or change of money going between parties after the fact. There is no up-front ability to simply describe how you want risks to be transferred. And as we've seen, and as Professor Scale has pointed out, we've seen the courts getting involved in trying to guess what people want after the fact, when in fact we have a contract that, while not exactly plain on its face, tries to actually describe all of the possible events and how payments are going to be determined.
 
Now court decisions that changes expectations after the fact, whether it's tort or contract, are disastrous because people get really upset about it of course. But I think it's even worse for contract, because they have tried to go out of their way to explain how they want risks and liabilities to be allocated.
 
So contract terms--this is kind of interesting because now I'm going to focus on economics of the insurance contract--and this is what keeps me excited at cocktail parties, everyone walks away, though--
 [Laughter.]
 
The terms of the insurance contract provide expectations about behavior. And the expectations are what the actuaries then go back and try to price. And we've seen lots of contract disputes, in life insurance, for example, where the actuaries didn't price something, and it's actually cost the insurers a lot of money. And we say, tough, you know. That's the cost of doing business. You made a mistake.
 
But what they did do is they looked at the contract and they say, well that costs zero so we're going to throw it away and give it as a marketing arrangement.
 
That's not the case in the typical property liability contract, where everything is priced very carefully. Insurance often has these extra-special rules of interpretation, which Professor Scales has mentioned, policyholder expectations, ambiguity is solved by providing coverage.
 
But the interesting thing about this is that Mississippi, the state of Mississippi's department of insurance approved this language. And this is not something where it just walks in the door and they say okay. They have 90 days or some length of time to approve it. It's not only been approved by Mississippi, it's been approved by a number of states. In fact, the language I showed you before was actually out of my Georgia homeowners insurance policy.
 
So this is almost a universally used and approved set of restrictions or exclusions on the insurance contract. So as Adam has pointed out, the insurance policy has been sort of gone over with a fine-toothed comb by courts and by regulators. So it's not something that's made up on the spur of the moment to deprive someone of rights. It's something without a lot of negotiation, but the insurance company doesn't have a lot of ability to negotiate this term either.
 
So Mississippi approved the policy language and the underlying assumptions for the pricing of the contract. The state of Mississippi thought that flood was included. They'd make sure for solvency reasons and for regulatory reasons that that flood charge was actually there. They never did that. So it's not there.
 
So let me just briefly talk about the attorney general's lawsuit. In many of these type of lawsuits in this where you actually make a lot of allegations and then as the trial gets closer or negotiations start accruing, you get to heat or the meat of the matter. But we have a violation of public policy argument that exclusions, per se, are against public policy. But lots of insurance contracts have exclusionary language. In fact, most people's automobile insurance doesn't cover them in the event of someone else hurting you that doesn't have insurance. You have to buy that separately.
 
My dental insurance doesn't cover my children's bad teeth in the sense that they're crooked. So I don't have any orthodontic coverage. So these are exclusions, and people have exclusions in contracts all of the time.
 
This is something interesting, because the attorney general says the exclusions violate Mississippi's common law, which he believes says that losses should be covered if proximate cause of loss is covered even if other causes are not. Well, proximate cause is a tort notion. It's not a contract notion. It's tort. And in doing this, it sounds like he's pushing a valued policy provision argument.
 
We also see the notion that exclusion is unconscionable because the contracts are complex and not subject to negotiation, and--I like this part--"and are reasonably favorable to insurers and oppressive to the policy holders and bear no reasonable relationship to the risk or the needs of the insurers." Well, I could actually see that there might be some argument to the first part, but the last part is ridiculous, because the insurers price these things. They definitely are related to the risk. So that's just, I guess, verbosity of some kind.
 
Another complaint is the water damage exclusion is ambiguous. Now if you look at it, it's right there. It says, "Water is excluded." Now people say you look at the rest of the contract and it gets confusing. But if we have a contract, I would argue that we need to be actually allowing people to contract and stop tortifying contract law, we have to set up reasonable expectations in the contract, not based on some third party reviewing it after there's a dispute. Because one person's reasonable expectations after a dispute is really different from what it was before the dispute.
 
We have the argument that it potentially violates the Mississippi consumer protection act. Exclusions of coverage are unfair or deceptive trade practices. Well, again, the department of insurance has gone over this with a fine-toothed comb with these notions in mind. And maybe they don't look at the Mississippi statute per se, but there's a long history in insurance regulation that regulators uphold that looks at the consumer protections aspects of insurance contracts.
 
And then we have irreparable injury. Of course, these people have suffered a loss. Just because you suffer a loss does not mean that the law treats you tremendously different given that you have a contract. You don't get any extra rights after the fact, is what I'm trying to get at.
 
This other lawsuit by the famous Mr. Scruggs that--it's not clear what it is because we haven't seen it yet--but he'll probably argue deception, something maybe like the valued policy provision. And because Mississippi and Louisiana have this in their law, he can make the argument that was made in Florida. He has the opportunity to do so.
 
The attorney general, I think, recognizes that his lawsuit is in some respects--maybe not 100 percent, but in some respects--a shot in the dark, trying to get some help for the people of Mississippi. But he's also asking for other help. He's asked Congress to do something.
 
And one of coastal Mississippi's representatives, Mr. Taylor, has proposed this ex post flood insurance program that Ted alluded to and Bob commented on. I'm not quite sure it's as goofy as Bob makes it out to be. It's possible that if you make them pay so many years backwards and force them to participate in it forever, put it in the deed so it's a deed restriction and it can't be removed, there's a possibility that that might not be a bad idea. And then it turns it away from this random public policy problem we have every time there's a hurricane. We get more people in the flood insurance program, and at least there's something there.
 
Now if the attorney general wins, what are some likely affects? And again, I'm not talking about the worst case scenario where all insurance dries up, all contracts become unenforceable in Mississippi, and things like that. Every time the insurance industry is stuck with an anomalous result, something outside of its recent experience, it tends to stop in its tracks and reevaluate.
 
Well, eventually they'll get around to coming back in the market and offering insurance. It's happened in the liability crisis of the '80s, the recent medical malpractice problems in various states. Insurers left the market. They left. They got up and left. There was an availability crisis.  This is likely to be a typical result if there's a tremendous amounts of uncertainty about whether flood risk is going to be covered by a homeowner's policy.
 
So in the short run, we have some availability problems where no one can get insurance, even with rules set up by the state to stop companies from cancelling policies. There's still going to be these kinds of problems.
 
There's also going to be pricing pressure. Mississippi's insurance market is going to see price increases. And one can argue about whether these are valid or not, but this is what the insurers do when they're faced with risk. They will want a risk premium.
 
There will be some insurer bankruptcies. Now the big companies, the name brand companies, you're not likely to see them going bankrupt, but you will see them wanting to retrench and leave the market.
 
We also have the possibility of contagions of this argument to other states and other lines. Med-mal and auto in some states are in critical condition, and having any more uncertainty about contracts makes them even worse.
 
And finally, because of all of these problems, we're going to have a call for greater intervention by state regulators. And we can look at the Florida example and say they haven't done a really good job. And there's also the possibility of federal intervention, which I'm not saying is good or bad, but it's a possibility that raises all sorts of uncertainties also.
 
Thank you. And I'll turn it back over to Ted.
 
MR. FRANK: Now, one question somebody might have is why do the insurance companies have the flood exclusion at all? Why not just cover for the flood and charge for it?
 
MR. GRACE: Well, maybe some people out here actually have a better understanding of the history than I do. But it has a long history of exclusion partially because in the old days--I'm talking 150, 100, 50 years ago--insurers tended to be small, regional operations, so a flood would affect all of its policy holders or many of them. And they couldn't afford that.
 
But as the industry has grown up and become more diversified geographically, internationally, and has the ability to access other kinds of financial markets, the ability of the insurance industry to actually diversify this risk has increased dramatically.
 
And so it may be that--and to be honest, I thought this before Katrina-- it's time for the insurance industry to step up and look at this anew. But that probably won't happen now because of the size of this particular loss.
 
MR. FRANK: I'd like to turn it over to the panel to comment on what they've heard so far or ask questions of one another. And I'll start with Professor Scales on my right and move on down.
 
MR. SCALES: That seems unfair, but I'll take it.
 [Laughter.]
 
I, too, have been thinking about the problem that Martin raises and why isn't the private market involved. And he's certainly correct that 100, 150 years ago, we did not have the kind of reinsurance mechanisms that we do today. And also, homeowner's policies were actually fire policies. The modern homeowner's policy is relatively recent.
 
But another problem, which you get some sense of from reading a very good, very informative CRS report from June of this year that looks at how the National Flood Insurance Program determines the actuarial rate. If I understand it correctly, looking at this and some material on earthquakes, you can predict relative rates, relative likelihood of flooding, but it's hard to predict the actual likelihood. You can say, well this area is more likely to flood than another area, but it's very difficult to measure. And in fact, there have been wild swings in the finances of the flood insurance program. And that, I think, has probably reinforced insurers in their view that skepticism is appropriate.
 
I think actually it would be a good idea to bring the private market into it as an information generating device, that the maps that are used by the National Flood Insurance Program are outdated. It's a billion dollar project to bring them forward. The incentives to do that are relatively limited. I think that this is something where private enterprise could actually succeed with it because the government has not, which is in reducing overall losses, but they would require some freedom to do that.
 
A couple other points. The idea that has been raised about retroactive flood insurance, I agree it's a different product if we're talking about putting this into the deed and a line of the covenant to run of the land, as we would say back in law school. I have some doubts about how feasible that would be. I am a little concerned about locking the present generation into what will probably be a somewhat untested technology in terms of risk distribution through that mechanism. But I think it's an idea that's worth thinking about.
 
One point where we do disagree is in the weight that should be given to the approval of the insurance language by the Mississippi Department of Insurance. Insurance contract language in any case in the past 30, 40 years has almost always been approved by the relevant insurance department. And while I agree that might go some way to knocking out a claim of fraud or manifest unconscionability, it really does not have much weight as an interpretive matter.
 And one last point about the Florida case that you mentioned. Florida has worked on its valued policy level, but now it's actually quite interesting. If a covered cause could have been sufficient to cause the loss, you must pay the value that you've set in the valued policy. So that seems to redescribe the problem somewhat. I don't think it really fixes it.
 Thank you.
 
MR. FRANK: Thank you.
 

Joanne.
 
MS. DOROSHOW: Just to address a couple of points about the Hood case, which is probably what a number of other cases are going to be relying on: The proximate and efficient cause argument in that case is actually extremely strong. What that means is, and this has been well settled in Mississippi law, is that if the jury finds that wind was a proximate and efficient cause of the damage, then that then obligates the homeowners' carrier to pay for that damage. And we're aware of at least three cases that went up to the supreme court there on this very issues.
 
It's very well settled. In fact, I think, I remember reading a burn case where the fact situation involved a house that where there was clearly wind damage as well as flooding. I mean there was an adjustor that went in and saw the water line around the house and saw, okay, there is this amount of damage due to flooding, but because the jury in the court found that the wind that preceded the flooding was the actual dominant cause of the damage to the home, it found that the homeowners carrier was responsible for paying for that.
 
I think that that is a very serious area of the law that the industry needs to deal with, that this is what the law is. And they've also known that this has been what the law has been.
 In terms of the ambiguity argument, it's not enough just to throw out language and laugh, and say, oh that seems very clear that that is excluding flood. If there are other things in the policy that seem to conflict with that, then the courts will always rule that it's ambiguous and that they will look to what the reasonable expectation of the policy holder is and how they might read it. And they're going to rule in favor of the policyholder in those situations.
 
So again, it's not so simple as the industry and some people are trying to make this out to be. I think that there are very, very strong legal arguments for the policy holders in these cases. And I would hope that rather than force these cases into court over and over again that the state insurance departments start requiring insurers to be siding on the side of the policyholders in these ambiguous cases and just pay the claim instead of forcing everybody into court.
 
MR. GRACE: Would you then recommend that because the loss is going to be higher if you pay every ambiguous claim, would they get to have a price increase to cover that?
 
MS. DOROSHOW: I think that price increases are completely out of line in this kind of situation. I think these kind of situations should have been anticipated in these models. I think that there should not be any surprise here, and I think the homeowner has already paid for these policies. And I don't think price increases are appropriate.
 
MR. GRACE: Well, insurance is a voluntary transaction. And we should think of people as stepping up to the plate to volunteer to be an insurance company and individuals volunteering to buy from it. There is no forced transaction here, except you might make the argument that the banks require homeowners' insurance. But you have the opportunity to shop for a number of them. And you don't have to actually own a house. So you have a lot of choice. And to say that we're going to restrict the ability of insurers to charge for the risks they're going to bear, that means that some people aren't going to want to bear it, and they're going to leave.
 
Now again, I'm not saying every one is going to leave, but it creates an environment where people are nervous and insurers are nervous and it makes it more problematical for companies to sell at the rates they think are necessary, and individuals may not get the coverage.
 So if there's no free lunch here, somebody always has the option to exit.
 
MR. FRANK: Adam, did you want to comment?
 
MR. SCALES: Well, sure. Again, I'm somewhat in between these two observations. I mean, the property casualty market has had a couple of very good years. But the picture is certainly mixed when you focus on some individual lines, and the extent of acceptable cross-subsidies is a very interesting question.
 
Insurance is a practical necessity for most people, but Martin is absolutely correct that the money is going to come from somewhere.
 
And I am not very proficient in writ-making [?] jurisprudence, but it does seem that one does have to recognize when there are interpretation issues that are fairly close calls, but are basically on the side of the policyholder and those interpretation issues where, again, if you were to take the Mississippi lawsuit literally, would without question be writing up these contracts if everything Mississippi was asking for not just some bit of everything they're asking for was upheld. And in such cases, I don't think it would be appropriate to say, well, that's a risk that the insurers have born.
 
They have borne some intermediate point, something more than what they have said in their policies and something less than the Mississippi AG is asking for.
 
MR. FRANK: We'll go to Bob now, and then I think Joanne wanted to say something else.
 
MR. KLEIN: Yes, as the only sole economist here, I'll comment on this pricing issue and sort of the market viability aspects of it.
 
Certainly insurers could contemplate (with the support of the federal government) inclusion of flood coverage in homeowner's policies. That would help make the coverage more seamless. It would help deal with situations where damages are ambiguous.
 
But, very importantly, the pricing would definitely have to reflect the risk. And there's two issues with that. Joanne mentioned something about the modeling. It's been done since Hurricane Andrew. And it's true, a lot of work has been done on that area. Prior to the hurricanes of last year, I think the insurers thought they had it just about right. There was a concern that regulators were still not allowing adequate rates in some of the highest risk hurricane areas. But generally, they thought they had it about right.
 
Well, here comes 2004 and now 2005, and the weather scientists are telling us, well, we may be in a cycle of several years of having one or two severe hurricanes hitting the southeast area. I can tell you very quickly that that's not something that was contemplated in the modeling. And that modeling is being reassessed. And if we are going to have a repeat of this type of experience over the next several years, the rates are going to have to come up considerably to reflect that higher risk.
 
So in the end, the bottom line is if you want people to come forward to invest in insurance companies that assume risk, whatever it be--wind, flood, flood and wind in areas where people like to live along coastal areas that are subject to these kinds of hazards--ultimately the premiums received are going to have to be comparable to the risk assumed. People are going to have to be prepared to pay that if they want insurance provided by voluntary firms.
 
Otherwise, turn it all over to the government and it can be a monopoly. It can be mandated and taxpayers can subsidize that just like they subsidize a lot of other things.
 
MS. DOROSHOW: Well, my question, how is it that the models could not have anticipated a hurricane of this force slamming into the Gulf Coast? That is what I don't understand. I mean, was this incompetence on the modelers’ part? You know, my understanding is that they were anticipating a category five hurricane smashing into Miami. So certainly this doesn't seem to be so off the projections and why it should be such a surprise in industry that this happened, where people live, where people suffered losses.
 
You know, after 9/11, there was a lot of screaming about this kind of thing, “We're going to suffer a tremendous loss,” the industry said. “Oh, my gosh, with today's rates.” And you know, that was coming after years of depressed prices and soft market and they didn't have a lot of cushion, I suppose. Or I'm not quite sure exactly how to articulate it, but they're making record breaking profits right now. This is a robust industry. There's no reason for them to be talking like this. And I really do hope that some of the rhetoric that's coming out of the industry is reconsidered, because I just don’t think that they need to be doing this. I don't think they need to be threatening the Gulf Coast, that they're going to leave this area. They don't need to be treating their policyholders this way.
 
MR. KLEIN: Let me quickly respond. It's true that the modeling did contemplate hurricanes of the severity of Katrina. However, those were events that might have been anticipated to occur once every 50 years, or once every 100 years. The industry wasn't really expecting to have a loss area like 2004, 2005, 2006 and 2007 occur all together at one time.
 Now the question of whether they have the financial capacity in terms of surplus to cover that event is one issue. Another issue is a question of being able to do that without significant financial impairment.
 
And as somebody that looks at the industry's financials every day, I do take issue with this notion that this is an industry flush with cash, that just can sort of dump it into their covering losses like this and continue to do so.
 
You have to understand that these are insurance markets that are priced for particular types of coverage. And you can't simply take a surplus from one segment of the industry and dump it all into homeowners' insurance every year because modeling estimates of years ago are incorrect, or it is suddenly decided that contracts need to be reinterpreted to add a bunch of new types of losses that had not been anticipated.
 
So I guess maybe we'll have more immediate opportunities to have discussions about what's rhetoric and what's reality and what's viable.
 
MR. FRANK: I'd like to turn it over to audience questioning.
 
QUESTION: I'm Robert Hershey. I'm a consulting engineer here in Washington, D.C.
 I wonder how estimates of wind damage are included in the models and how those reflected in coverage? [approximation of question, which was inaudible on tape]
 
MR. KLEIN: Well, I'm the person to try to respond to that.
 I can't give you many specifics. Clearly, in areas that face a significant amount of wind risk there is a loading for that. And that's going to be part of the premium that's collected every year and presumably when it's not needed, it's put into surplus and it's drawn upon, you know, when there are high wind loses.
 
But again, it's based on modeling, based on return periods of a number of years. And those provisions become inadequate if there's a significant change in the assumptions that should underlie the models such as the weather cycles that we're seeing today.
 
So I'm not sure I responded to your question, but there is an element in the pricing to reflect that. But again, it's based on a lot of assumptions that if those assumptions change-- in other words, the world changes, and the assumptions are no longer correct--that requires a change in the pricing.
 
QUESTION: My name is Bert Ely and I'm a banking consultant here in the Washington area.
 
A comment and a question. First of all, why flood insurance doesn't seem to work in the private market place. And there's a very good reason for that, and that is the federal government has undercut it routinely over the decades with disaster assistance programs.
 
My question relates to mold, which of course has been a very controversial issue for the insurance industry, particularly in Texas. But here we have a number of situations, as I understand it, where the deciding factors as to whether or not a structure has to be torn down and therefore a total loss revolves around the mold damage that comes on subsequent to either flooding or rain. How is that going to factor into these cases? Is this going to generate even more litigation, which then leads to the question do the state courts in the affected states have the capacity at this time to handle litigation? If they don't, how are they going to deal with that problem?
 
MR SCALES: Are you suggesting that litigation be spread like a giant fungus?
 [Laughter.]
 
Because that has been a huge issue. And once again there's mold and there's mold. So there is the ordinary mold that has captured the nation's attention in over the past five or six years, lurking unseen in basements and things like that. But then there's mold that occurs ancillary to windstorm damage, which has happened in New Orleans.
 
Now there are some specific restrictions for mold damage that is the result of a covered peril. And I think that is going to mean that there are large arguments about whether those restrictions, which are often reasonably clear, should be enforced. But if you had a normal mold exclusion, it would generally not apply once there has been a windstorm loss.
 
But once again, we have a huge factual question. There was wind, rain comes in, and we've all been following the weather in New Orleans. And of course, there is some flooding. I have no idea how someone could determine what percentage of mold resulted from the wind damage that tears off the roof and what the resulted from the background conditions.
 
MR. FRANK: Yes, sir.
 
QUESTION: Fred Smith, Competitive Enterprise Institute. You know, since George Priest isn’t here, someone should ask the general question about the relative performance of private insurance versus political insurance. We would argue, as you know, that government insurance is not exactly the same thing. It's exacerbates moral hazard, adverse selection, et cetera.
 
But what I'm really interested in is the way in which the flood issue has become more significant, what are the policy variables that made it harder for a private flood insurance to go? You've mentioned already the class of contract that Professor Scales has mentioned. You've indicated that the smaller nature of insurance firms make it harder to risk spread. And of course, there's one other, that 100 years ago rich people didn't live in flood plains. They were hillbillies and river rats basically. Only when rich people got there, did insurance demand go up. And during that period, we began to politicize the insurance market.
 
But if you look at the two experiments that are ongoing now, the home insurance markets, which is largely private and the flood insurance market, which is almost totally political. You mentioned the coverage of flood insurance. What's a comparable coverage of home improvement insurance and how does that very between homes that are still under mortgage and homes that are fully paid off? To what extent has the penetration indicated that there has been a source of responsible provider of insurance, private versus political?
 
MR. KLEIN: That's a very interesting question, Fred. I think that probably most of the factors would support a viable private flood insurance market for residences if the regulatory system allowed appropriate pricing and rating.
 
There's maybe one aspect of this that I will point out that will be an issue, and there might be other issues that insurers would raise that would be legitimate concerns. And that issue would be flood mitigation and control. And ideally, that could all be accomplished through private incentives. In other words, if you have to pay more because the city where you lived didn't do a very good job in flood mitigation, then presumably that provides the appropriate incentives. And that's essentially what the flood insurance program tries to do.
 
Again, that conceivably that could all be accomplished privately. One big question mark that I'm sure insurers would have and I would have is, would the regulatory process allow the rates to really truly be actuarially based, including with appropriate catastrophe modeling and adjusted catastrophe modeling as assumptions in the world change, particularly flood plains change very quickly. And so that would certainly be an aspect to consider.
 
MR. GRACE: Is what's interesting is there's a mini-version of this kind of processing going on now. I.S.O. and other organizations rate communities for their police and fire protection. And I've been reading in the last year when I.S.O. says, “Hey, this police department and fire department are now operating better, more effectively.” There's a notice in the paper; homeowner's insurance rates are going to go down because of this. And that has made a difference in homeowner's rates.
 
Fire and crime are not as sexy as floods and other disasters, but, on the margin, these private organizations are actually doing that and cities and local governments are responding. So I think there's a potential here for lots of changes and how flood plains are managed if it was put in private hands.
 
That would probably make you happy.
 [Laughter.]
 
MR. SCALES: If I may add to what Bob said, I do think that, you know, there is a great deal of difficulty in persuading policy makers to allow the market to work efficiently, particularly when there are income distribution issues that have been brought into riveting view.
 
John Tierney in the New York Times a few weeks ago suggested that we have the private market for flood insurance. We would create an incentive for insurers to undertake the kind of flood plain management efforts that are so haphazard now. I would like to buy that argument. It certainly appeals to my inner back-of-the-envelope economist. But I wonder whether the experience of Florida really sustains that. Insurers have been on the hook for various wind-related damages. It takes a tremendous effort, and many years for homes to be brought up to modern standards for resistance of damage. And you have a number of interest groups that would prefer to build things less expensively. And perhaps in the case of flood plains, would like to build something there.
 
And I think it's an open question whether insurers could get enough control of the inputs here in order to make this viable.
 
QUESTION: Good morning. My name is Dick Sanderson. By way of background, I spent 42 years in the federal government. I'm a consultant here in town with an outfit called Dawson and Associates. Ten of those years were with FEMA and its predecessor agencies. During those years I had both the disaster response program and the flood plain management and mapping program.
 
The thing that I think is significant is that most people don't recognize that the flood insurance program was put together after a group of officials in a natural kind of hazards program in Colorado looked at it as a mitigation measure. It was only underwritten at a mitigation measure to keep people out of the flood plains and flood waters.
 
The difficulty is most people looked at it as a one in one hundred percent chance. When they hear a hundred year flood, they think, oh, yeah, the storm last years; ninety nine years I'm fine. That's the not the way it is. It's a 1 percent chance in any given year that it's going to happen.
 The second issue that I'll make--I will give you, if I may, a 15-second anecdote. I was in Abbyville, down in Vermillion Parish in Louisiana in the early '80s. I had a model which showed what a 19.5 foot storm surge what it would do to the community and the town. One fellow finally stood up where I was talking and said, well, Mr. Sanderson, “Does that mean I have to have a 19.5 foot front porch?”
 [Laughter.]
 
I said, “That's what the model shows if you're going to have a structural mitigation.” He said, “Mr. Sanderson, I'm in a lot more danger from missing that first step on Saturday night--[Laughter.]--than I am waiting for that hundred year flood to come back.”
 
That's your problem with the kind of discussion you're having.
 
MR. FRANK: Anybody? Okay.
 
QUESTION: Hello, thanks. Jim Whittle with the American Insurance Association.
 
One of the things that I've heard today repeatedly from the panel is the concept of reasonable expectations. And my understanding of that is it's actually a contract construction doctrine that is only employed if there is actual ambiguity in the contract.
 
I wanted to know, first of all, if we know if that is the state of the law in the Gulf states, that reasonable expectation doctrine does apply.
 
And I guess secondly, the question I have is, my understanding of the conversation that's occurred today is we're talking about what policy holders knew or didn't know. But the idea that it's ambiguous, that they didn't expect that they didn't have coverage, the idea that things were being sold as if there was coverage, but the question I have then is, how do you explain that to the millions of people who bought and actually paid premiums for flood insurance?
 
MR. SCALES:  There's no question that people have a great deal of difficulty answering basic questions about their insurance policy.
 
I'll bet I could ask you a question on the good rate of products coverage that you might know the answer to off the top of your head, but that doesn't mean of course that you just give everything away. I mean, I think that is an irresponsible standard.
 
There are two different expressions of the reasonable expectations principle. One is the strong form that would say, I don't care how clear it is in the contract, the customer expects X level of protection if he's buying a homeowners' policy and he's going to get it.
 
Now that strong form comes into play relatively rarely, particular in Southern States. However, the weaker form is the interpretative principle. And there are relatively few interesting events that when strained through insurance language, cannot contain a taint of ambiguity.
 I agree that insurance has gone about as far as they can in trying to exclude any flood driven losses. But they would still have to explain why, by in large, they would still pay for the portion that they determine retrospectively they attribute to a windstorm.
 
This means reform of reasonable expectations which exerts a very subtle gravitational effect on the way courts plumb the policy for ambiguity. That is why it spreads. You can find cases in Mississippi quite recently. The courts are adopting exactly the principle you are describing. And you can find the relatively recent case in Mississippi where courts are achieving results that are one would predict if a court were using the doctrine.
 
So it is a widespread and characteristically somewhat unpredictable doctrine. But I expect it to play a role here.
 
MS. DOROSHOW: And just in terms of what we've been hearing from people as to why they didn't purchase flood insurance. You know, as I said earlier, some people were told by their agents they didn't need it, they weren't in a flood plain.
 
And as one of the callers to our hotline said, “He said he offered me a deal. He said I didn't need flood.” Somebody offers you a deal, you take it. And that was an obvious sales pitch to her. I don't know whether it was because she was in competition with other agents over this particular policy holder. I don't know why that was. That was several years ago. We can't really track down the agent. We're trying actually to do that to find out.
 
The other typical situation is somebody purchased the policy and had a hurricane endorsement with a hurricane deductible. People thought it wasn't well explained to them that they didn't have flood coverage, and it was only when this particular policy holder made the extra call to the agent and found that out, did the agent explain flood was not part of this. And so she went ahead and purchased flood because of that.
 
We also have heard stories that, before the hurricane, FEMA was trying to spread the news, that the levees were going to hold, don't worry, you don't need flood insurance. The levees are going to hold.
 
So, you know, there's just a lot of information that people were getting. Misinformation really comes down to that level of what people are hearing, what people are being told by their agents.
 
MR. SCALES: Let me just add something to that. You know, the anecdote that was given is very characteristic of the difficulty people have in processing remote events. People really do believe, in fact I read an account of someone who is going back to New Orleans and said, well, we had our 100 year flood, so I guess I'm fine.
 
It's not clear to me that if you required all homeowners’ contracts to be accompanied by a detailed statement and put together that describes the risks of loss, I'm not really sure we'd get tremendously different results than we have now. And that creates a significant public policy problem. Yes, there is a part of me that's very sympathetic to letting those chips fall where they may, but historically, that's never what happens. That is never ever what happens. There have been flood remediation and compensation programs going back to the 1830s. This is just the most recent iteration of it.
 
It seems to me that we're very likely to be paying, and the question is whether we're going to pay as taxpayers or we're going to pay as policyholders.
 
QUESTION: I’m Ray Lehmann, from A.M. Best. I was just wondering, to what extent do you think these disputes are related to the fact that the coverages are not the same? On a flood policy you have a cap of $250,000 on the homeowners and you don't get, for instance, extra living expenses. If you made a single policy that was a form-following policy where the portion that is flood would be paid by the Federal Flood Insurance Program, but that dispute would be simply between the insurer and the government and not the policyholder. If you remove the policyholder from the argument you don't get this kind of litigation explosion.
 
MR. SCALES: Yes, it's an interesting idea. You could have a hybrid model where the government maintains its underwriting function and the write-your-own insurers are administering the flood part of their policies along with their resident policies. If nothing else, you would push the disputes from the retail to the wholesale level and those disputes can be resolved much more efficiently.
 
MR. GRACE: I was just going to say I agree with that. That's a good idea. It takes the person least able to bear the risk out of the problem.
 
QUESTION: I'm Keith Watson. I'm a lawyer for the insurance companies. My question is, and it really relates to a couple of the prior questions: are the property insurers today being asked to pay claims that would have been covered by the flood insurance policy if the homeowner had purchased the flood insurance?
 
There's a second part of the question, and that is, isn't a flood insurance marketed expressly on the grounds that your standard homeowner’s policy does not cover flood insurance? I believe I have seen a lot of literature marketing by the flood insurance people that says we're here because your policy doesn't cover it. Is there an inherent unfairness in asking private insurers to pay for coverage that could have been purchased through the government?
 
MR. KLEIN: I'll just quickly add one comment and let others speak. Yes, there is extensive information put out there that homeowner insurance does not cover flood. There is a Federal Flood Insurance Program, and you should contact your agent or your insurance company or the Flood Insurance Program to purchase flood insurance. If you read any brochure issued by any insurance department about homeowner's insurance, it'll talk to you about the fact that flood is excluded, including storm surge if that's appropriate to that state, and that you should consider buying flood insurance and that this is how you do it.
 
So although apparently there are some people that are unclear about this and might view their contracts as ambiguous, there has been, at least from what I've seen, a significant effort to try to make the point that people should buy flood insurance and to tell them it's not covered by their homeowner's insurance.
 
QUESTION: Mark Crane with USA Today Editorial Page. Sort of in line with the last question, if the attorney general's suit succeeds or Dickie Scruggs' suit does, what possible incentive would there be for anybody to buy flood insurance if they could simply get the kind of coverage after the fact?
 
MR. SCALES: There's a serious risk which our economists would be happy to expound upon at length.
 [Laughter.]
 
MR. GRACE: It'll destroy private insurance markets, maybe not to the extent that we'll never see this again, but for the next so many months insurance will be hard to come by. Just think of the redevelopment issues that are in Louisiana and Mississippi right now where there's going to be rebuilding. No contractors will be able to get insurance. Things will just grind to a halt while all this is repriced and new strategies for dealing with this particular contract evolve, and that won't happen overnight.
 
Then at the end there's still going to be the risk that they didn't go far enough in pricing for this risk and then there will be an issue, can we put that into the rate and people will say no, and then insurers will say, “I don't know if I want to do this.”
 
So there's a public policy issue here and it's not the contract versus tort policy, it's how we keep the insurance markets viable next year and the year after and the year after when we have another catastrophe.
 
MS. DOROSHOW: I would just say it depends on the claims that they win on. There are some very strong legal claims here and there is no reason for them to lose these cases, and the insurance companies ought to be paying these claims. They should be paying these homeowners' claims when there is wind damage, and that's what part of these suits are about. I think there's a lot of fear-mongering going on and that is why the government needs to step in, particularly the state insurance regulators need to step in and say wait a minute, you can't pull out. There's got to be a moratorium right now and then we have to figure out how we're going to handle this.
 
You cannot let these companies just leave, and that's what happened after Andrew. There were threats to do that. Regulators came in and stopped it. Louisiana has already done that with an emergency rule. They need to do that in Mississippi. There needs to be some time before this can all be reevaluated and it all needs to be sorted out.
 
MR. GRACE: I do agree that legitimate claims have to be paid, but let's look at Florida after Andrew. The biggest risk holder, or the second biggest risk owner in homeowner's insurance is the taxpayers of the state of Florida. Companies have left. In addition, they've carved themselves up into separate subsidiaries operating within the state to reduce the risk to the rest of their business of a Florida catastrophe that they don't think they're being able to price for.
 
So the insurance market in Florida is not something we need to say is a shining example of what could happen if the government gets involved. Let's say it's muddled along and it's had its good years and it's had its bad years, but it's not something we want to aspire to for the rest of the country.
 
QUESTION: Fred Smith, CEI. Recall that in other insurance markets where you force small subsidies, you end up you can get into the market but you can't get out. We call that the roach motel problem. It's a real difficulty.
 
I have a place on the Potomac River now and we're just outside of what the government calls a flood plain. You can't insure your piers and decking area. That's not insurable because there's no private market and there's no government market. We're outside the flood plain, so we don't get government insurance, and if we did, our home now is more than 250 so we'd be capped in that situation.
 
It looks like we've already destroyed the private insurance market for people like myself. We're about to it looks like destroy even more.
 
QUESTION: Again with regard to flood insurance, I think the idea of combining or rolling flood insurance into the homeowner's policy and then having the government pick up that piece of the loss is an interesting idea. Someone said it raises the disputes to the wholesale level and takes the homeowner out of it.
 
However, there is still a fundamental philosophical question, and that is in addition to the coverage caps that Fred talked about, the Federal Flood Insurance Program's pricing is based on normal loss years, does not have catastrophe built into it. Then any time we get a serious catastrophic situation, and of course that's why we have flood insurance in the first place, the federal government rides in with taxpayer assistance.
 
Is there any way to construct a flood insurance program that covers even catastrophic situations that can put all of the loss recovery on the policyholders rather than on the general taxpayer? It seems to me that until you can pull the taxpayer out of the equation with certainty, you can never have a properly structured, properly priced flood insurance program that through pricing will lead to a lot of the mitigation efforts that we all think are important to minimize losses. Any thoughts about how to get and keep the taxpayer out of the picture?
 
MR. SCALES: As soon as we balance the budget and we control the tendencies of the government to